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Universidad Carlos III de Madrid – Department of Economics

Principle of Economics
Problem Set 7

Conceptual Questions

1. When do we say that there is an externality? What are the types of externalities according to
their impact and their origin? Give several examples of different types of externality.

An outsider of the transaction between the seller and buyer that impacts them positively or
negatively. When an exchange in a market affects a third party

2. When is there a negative externality in production or in consumption? In such case, why is

market quantity greater than that socially optimal?

(Social cost)- There is a negative externality in production when producers of a good impose a cost
upon a party who is not producing nor demanding the good itself. In consumption, consumers
impose a ocst on a third party that is neither a consumer nor a producer of the good. The market q is
greater than the socially optimal q bc the MgC

3. Compare the consequences of a negative externality with the consequences of a positive

externality.

A negative externality implies

4. How can you make firms take into account external effects of their actions? How can you
bring the market production closer to the socially optimal production? Give examples of
private and public solutions. What does the Coase Theorem say about that?

Public solutions for externalities are regulations on quantities, regulations on prices, taxes or
subsidies, creation of NGOs, moral codes.

Private solutions in line with the COASE THEOREM is to define property rights on all the goods
that are relevant for the externality.

5. What do we mean by excludable goods? What is rivalry in consumption? What is a public

good? Give examples of public goods. What differentiates a public good from a common
resource?

Excludable goods are goods that can be excluded to some people. (to see a movie first you need to
buy a ticket). Rivalry in consumption is when the quantity consumed by someone can not be
consumed by someone else. Public goods are not excludable and don’t have a rivalry in
consumption.

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 Problems

Marginal
Income of Marginal
income of Total (social)
each fishing social income
Number of Total cost of Marginal cost each fishing income due to
vessel due to
lighthouses lighthouses of lighthouses vessel lighthouses
attributable lighthouses
attributable (N=8)
to lighthouses (N=8)
to lighthouses
0 0 -  0 -  - -
1 80,000 80,000 10,000 10,000 80,000 80,000
2 160,000 80,000 16,000 6,000 128,000 48,000
3 240,000 80,000 18,000 2,000 144,000 16,000
4 320,000 80,000 19,000 1,000 152,000 8,000

6. Fishing vessels operating at night near the Spanish coast are concerned about their safety. Due to
the crises, the government is unable to finance the construction and management of lighthouses
along the coast. For this reason, fishers have decided to join forces for doing it themselves. The cost
of building and maintaining a lighthouse is 80,000 Euros, but lighthouses contribute to increase
income of fishermen by the amounts indicated in the table below.

Table 1 Given 8 fishing boats

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a) Explain why a lighthouse is a public good.

b) Calculate the marginal cost of the lighthouses and marginal income of individual fishing boat
according to the number of operating lighthouses on the coast. Also calculate total (social) income
and social marginal revenue, assuming that there are 8 fishing boats in business.

c) If only one boat owner were to cover the cost of its navigation aid from lighthouses, will he do it?
How many boats are needed to make the social marginal income due to lighthouses equal to the
marginal cost of building and operating a lighthouse?

d) If there are 15 boats and their owners all agree to pay the cost of building and operating the
lighthouses, how many lighthouses would be put into operation? How many vessels are needed for
3 lighthouses to be in place and working? And how many boasts are needed for having 4
lighthouses instead of three? Why is it necessary to increase the number of boats that defray the cost
of lighthouses in order to have three lighthouses in operation instead of two, or 4 instead of 3?

Other Questions

7. A tax on pollution caused by chemical factories discharging into a river:

a) Induce the firm to reduce the polluting production because it makes them internalize the external
costs of such production.
b) Should be equal to the marginal external cost of discharges.
c) Has the same effect as tradable discharge permits to the extent that sets a limit on production
equal to the socially optimal production. This is because the opportunity cost of permits acts as a tax
on pollution, we call such a tax Pigovian.
d) All the above statements are correct.

8. Currently, two companies of electric power, Powerama and Watts-Are-Us, each emits 100 units
of pollution. Each company has the ability to "clean its own production" at some cost. The cost of
eliminating each unit of pollution is 200 Euros for Powerama and 300 Euros for Watts-Are-Us. The
government establishes a program of tradable pollution permits, so that each company must have a
permit for each unit of pollution it emits. The Government issued a total of 100 permits, 50 permits
for each company. If the two companies can trade permits with each other, what would be the likely
outcome?

a) Powerama completely eliminates its own pollution and sells all its permits to Watts-Are-Us.
b) Watts-Are-Us completely eliminates its own pollution and sells all its permits to Powerama.

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 Problem (solved)
A vaccine against the flu reduces the likelihood of contracting the virus and, thus, the risk of
infecting another person. All individuals who are vaccinated generate the same externality to
society, but each has a different marginal utility (private value) to be vaccinated. We assume that
the cost of each vaccine is constant and equal to the marginal social cost.

A) Represent graphically the market equilibrium and compare it with socially optimal allocation.

Supply

Social value
D

Q
Maket Q Optimal Q

B) Identify the welfare loss caused by market allocation in comparison with the socially optimal
allocation.

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C) Discuss what measures could be taken to mitigate the loss of welfare. Do you think it would be
efficient to provide free vaccine to all individuals in society? For whom this would be just a pure
transfer of income?

Suppose that the marginal utility (private value) of all individuals is the same, but the society is
divided into two groups of equal size: those who generate a small externality once they have been
vaccinated and those who generate a greater externality once they have been vaccinated.
Furthermore, suppose that the marginal cost of producing the vaccines is increasing and linear.

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D) Give two examples that would be included in each group. Think of teachers, doctors, nurses…

- Greater externality: people who are in contact with a lot of people or in contact 
with children (teachers, doctors) o people whose work performance is very important 
for society (teachers, doctors, government ministers, president of the country).
- Smaller externality: the rest of the population.

E) Suppose that the current allocation is such that the marginal cost of vaccinating an individual is
equal to the private value of been vaccinated. In which group do you think all its members should
be vaccinated? How do you calculate the percentage of members of the other group that should
undergo vaccination if not all?

P Marginal Cost (Supply)

Social Marginal Utility

Private Marginal Utility (Demand)